Are mutual funds safe? Can mutual funds run away with our money or become bankrupt?

Are mutual funds safe? Can mutual fund run away with our money or become bankrupt? This should not be dismissed as a newbie question. It is one of the first and most important considerations before investing in a mutual fund. We certainly have instances in the past where fund managers could invest where they want, change from debt to equity and value the fund anyway they like UTI 64 debacle. Also, see this old outlook article. As usual, our administrators react (and not pro-act) after something “bad” happens and hence was born the SEBI MutualFund Regulations act 1996.

This post is inspired by two reasons: Thanks to a question by Dheeraj Barnwal at FB group, Asan Ideas for Wealth (not the first time a new investor has asked this). I am working on a 100 questions on Mutual funds e-book for new investors and this post will serve as a detailed answer to the titular question.

Are mutual funds safe? Can mutual funds run away with our money or become bankrupt?

Short answer: Fact: They are a lot safer now than they were 22 years ago with high levels of transparency and stringent disclosure requirements. If you are looking for a yes or no answer, then your question is wrong.

Can mutual funds go bankrupt? Any business can go bankrupt. this means that their expenses and debt are so high and profits so low that they cannot continue any more. The point to understand is that they cannot go bankrupt with our money!

While they invest our money, they are investing it for us and not for themselves. So if they get it wrong, the NAV can crash and we make a huge loss. There are many funds which have destroyed investor wealth this way. Even then, the fund house will get paid via the expense ratio! So even a terrible mutual fund will make money as long as it has enough investors in it.

When a fund house repeatedly makes losses (this has nothing to do with the performance of their mutual funds), it will simply sell the business to someone else (willing to buy) or inform the investors that the fund is to be closed and return their money = current value of units held.

Are mutual funds safe? Mutual funds are subject to ignorance risks. If you believe what the fund houses or sales guys say about the “benefits of mutual funds” without understanding investment risks, then they are not safe. If you started investing in mutual funds because of some ads in between an IPL match then they are not safe.

The risks associated with the stability and safety of the scheme are low thanks to SEBI regulations. The risks associated with investments are governed by how much you understand them. The point I am trying to make is: if you are worried that your money will vanish one morning then that is unlikely to happen. You should be worried about the possibility of your investment value diminishing overnight by 20% or 40% due to a market crash.

Do not cofuse saftey of the product with saftey of your investment!

Let us ask the right questions:

1: Will I know where a mutual fund invests its money? Yes via monthly disclosures. This is the full list of statutory disclosures

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2: How do I know the NAV is correct? The valuation is strictly on market value and this is audited regularly. See presentation below.

3: How is my money protected? Mutual funds have a board of members known as the custodians whose primary job is investor protection. Custodians are responsible for keeping the fund securities safe and account for transactions. They should not be affiliated with the sponsors of the MF company. Custodians are audited periodically and the report must be sent to SEBI.

The Registrars and Transfer Agents like CAMS or Karvy form a bridge between investors and the custodians. They handle customer compliance like KYC and process investments and redemptions. They are also periodically audited.

4: Can fund houses invest anywhere they like? No, there are guidelines by SEBI (see presentation below). Also, they have to adhere to the pattern mentioned in the scheme document (which is pretty broad!). If they wish to deviate, they will have to inform investors and offer them a chance to exit without load.

5: Can fund houses invest any way they like? No, there are guidelines by SEBI (see presentation below). Also, they have to adhere to the pattern mentioned in the scheme document (which is pretty broad!). If you don’t like the freedom that fund managers enjoy as per the scheme document, then don’t use mutual funds.

Over the years SEBI has mandated several disclosures (linked above), got rid of exit load, introduced direct plans, introduced registered investment advisor regulations, limited the amount of stock and bond exposure in a fund, ruled that redemptions cannot be stopped due to the funds mistake, introduce new scheme categories, introduced and modified risk scales, made fund houses disclose commissions. So it has helped investors significantly.

Of course, some things have not worked, like investment advisor regulations which have done nothing to reduce conflict of interest, Of course, it has also made unnecessary rules like making current investors pay for “investment awareness” which has been used for profit by the amcs. Of course, there is room for improvement: make commissions based on each invested value and not on market value (get rid of trail commission), ensure mutual fund salespeople do not offer investment advice ..

All said, SEBI has done a fantastic job in protecting mutual fund investors and it is a work in progress like anything else.

All of the above were short answers! If you want long answers, please take some time in reading the following two presentations from the western India regional council of The Institute of Chartered Accountants Of India. Save these two presentations in case, they are removed later.

Structure of a mutual fund and how the entities are audited

Easily the most comprehensive yet easy to understand resource on Internal Audit of Mutual Funds and Portfolio Managers

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